US investors seek profit on Brazil rate hike

Doubts remain whether the real will sink further and wipe out returns on bonds

NEW YORK — Brazil’s decision to hike its key interest rate to 11 percent, its highest level in two years, has some yield-hungry US investors smacking their lips.

After all, they argue Brazil has an upside and may carry less risk than the other BRIC countries of Russia, India and China. Hopes that Brazil’s next president to be elected in October will rein in spending and adjust macroeconomic policies sparked a rally in domestic markets in the past few days.

The big question is whether Brazil’s currency, the real, will sink further and wipe out returns on real-denominated bonds. For some the danger is modest enough to handle, especially for the sweet double digit yields.

“When you look around at the local emerging market debt market, Brazil actually looks very attractive,” said Gerardo Rodríguez, senior investment strategist for BlackRock’s emerging markets group. “There was some uncertainty in the policy mix, but now with the Central Bank being more aggressive on the tightening cycle, you’re having some stability and it has been a good entry point for many investors, especially on the long end of the curve.”

Brazil’s Central Bank on Wednesday raised interest rates for the ninth straight time, extending one of the world’s longest rate tightening cycles after a surge in food prices added to the country’s already high inflation. Since April 2013, the Central Bank has increased its benchmark interest rate 3.75 percentage points.

That has prompted some investors, who had been rushing out of the country’s equity market over concerns about high inflation and tepid growth, to consider Brazilian bonds. Brazil’s 10-year bond yields 12.8 percent in local currency, according to Thomson Reuters data, compared with a yield of 2.79 percent for a 10-year note in the United States.

“If you’re an investor (in the Brazilian market) sitting on money, and you’re saying where should I put my next incremental investment, the rates you’re going to get in that bond market just got more attractive,” said Dave Nadig, chief investment officer at San Francisco-based research and analytics firm ETF.com. “That’s where there’s an immediate direct impact.”

Inflation risks

Investors who buy fixed income securities run the risk that inflation will continue to cut into real returns. On March 27, Brazil’s central bank increased its 2014 inflation forecast to 6.1 percent from its earlier estimate of 5.7 percent, and raised its 2015 inflation estimate to 5.5 percent from 5.4 percent.

Those moves have come amid wide swings in the value of Brazil’s currency. Since January 2013, the value of the real against the dollar has fallen approximately 15 percent, from 1.96 per dollar to 2.26. Should the real continue to fall, US-based investors who convert their earnings from reais to US dollars will see the value of their positions erode.

US investors typically cannot buy Brazilian bonds directly unless they put in a large order through their broker. And, with no exchange-traded funds investing solely in Brazilian debt, analysts say the best alternative are emerging markets bond ETFs which count Brazil among their largest country allocations.

The WisdomTree Emerging Markets Local Debt Fund ELD.P, for example, has its third largest country allocation, roughly 10.6 percent, in Brazil. The fund, which invests in bonds denominated in emerging market currencies, has gained about 4.5 percent over the past two months, since falling in late January.

For those that want to hedge out exposure to the real, the Vanguard Emerging Markets Government Bond ETF — with its second largest country weighting in Brazil — and the iShares J.P. Morgan USD Emerging Markets Bond ETF, track bonds denominated in US dollars. The Vanguard fund, launched just last year, is up about 3 percent since early February, while the iShares fund is up about 3.8 percent since then.

Going for dollar-denominated debt

The volatility of the Brazilian real makes buying Brazilian bonds unattractive for some investors, despite the alluring yields. Instead, some fund managers say they are buying Brazilian corporate bonds that are denominated in dollars rather than adding bonds issued in the real, effectively trading a safer currency for lower yields.

“You’re just not getting paid enough to take on the risk,” that Brazilian inflation will cut the real’s buying power against the dollar, said John Lekas, a senior portfolio manager at Leader Capital who oversees roughly $1 billion in assets among two funds.

Though Brazilian sovereign bonds carry investment grade credit ratings, their corporate counterparts issued in dollars allow a better way to tap into the Brazilian economy without taking a currency risk, Lekas said.

Instead, he has been buying bonds issued in dollars by Brazilian industrial, materials and telecommunications firms. For example, he recently took a position in dollar-denominated bonds issued by telephone company Oi that matures in six years and pays an interest rate of 5.7 percent.

Jenelle Woodward, director of research at BMO TCH, which runs the BMO TCH Emerging Markets Bond Fund, said that Brazil’s rampant inflation will likely eat into real returns. The fund instead has been picking up dollar-denominated bonds issued by global companies headquartered in Brazil, such as a 10-year bond issued by energy company Petrobras that yields approximately 6 percent.

Equity opportunities for long-term investors

Even as US investors shy away from Brazilian equities and go towards bonds, some see long-term opportunity in the country’s stocks, which have been selling off. Brazil’s benchmark Bovespa index had fallen some 12.7 percent from Jan 1 through mid-March, but has been on the ascent in recent weeks.

“Valuations in the equities space are starting to look attractive,” said BlackRock’s Rodríguez.

While most Brazilian stocks pay a dividend, there are few direct ways for fund investors to focus on dividend-paying stocks. The US$4.3 billion MSCI iShares Brazil Capped fund, for example, offers a dividend yield of 3.2 percent, a level slightly less than the 4.3 percent yield of the broader WidsomTree Emerging Markets Equity ETF.

“Emerging markets are much more volatile, but if you stay invested through the investment cycle, you can expect to get double digit returns,” Rodríguez said.

Still many say they are in no rush to get into equities.

Right now, “you’re really stuck between a rock and a hard place” with Brazil, said King Lip, chief investment officer at San Francisco-based Baker Avenue Asset Management.

“We think it has further to fall before we see a rebound,” Lip said. “I’d rather be investing in bonds than equities right now because I do believe eventually inflation will be controlled and they’re going to be happy to reduce rates to stimulate the economy and then bonds are going to be rallying on that.”